James Graves Posts 409A Valuation Information on Blog For Startups

The Best Way to Undergo a 409a Valuation

The Independent Appraisal Method

The best way to undergo a 409a valuation is via an independent, professional appraisal of the company’s FMV done by companies like Carta or Scalar, called the “Independent Appraisal” method.*  Why? Because the law gives the professional appraisal of the FMV of a company’s stock a rebuttable presumption of reasonableness.  This means that if the IRS ever audited the company, the burden of proof would be on the IRS, not the company, to show that the methodology used was not a  “reasonable valuation methodology.”  This dramatically reduces the likelihood of a successful IRS challenge of FMV.

Be Careful Doing It By Yourself

Compare this to if the company used a different appraisal method, such as doing it by itself.  In this case, the burden of proof would be on the company to demonstrate it used a reasonable valuation methodology.  This is expensive, time-consuming, and highly burdensome to prove.  Even if the company were 100% correct, it would take time and money the company could otherwise invest elsewhere to meet its burden of proof.

Further, the company runs the steep risk that it simply did not use a reasonable valuation methodology.  You are in the business of running your company, not valuing shares of stock.  You are, therefore, by definition, probably not qualified to do so.  Why run the risk when the adverse consequences are so dire?

My one caveat here is this. If you are a brand new company, say, less than a year old, you probably can rely on a good-faith valuation of your shares than you do yourself since the shares’ value would be so nominal.  However, as you grow, start considering an Independent Appraisal sooner rather than later.

Your Employees May Be Penalized By The IRS The Most For Your Non-Compliance

What’s more, the tax penalties for violating Section 409a are not imposed on the company.  They are imposed on the company’s service providers (e.g., employees or independent contractors) unless the company fails to report or withhold any amount that becomes taxable because of a failure to comply with Section 409a.  These penalties include:

  • All vested deferred compensation (e.g., options or restricted stock) becomes taxable immediately.
  • An additional 20% penalty tax levied on the service provider on top of regular income tax.
  • Possible imposition of interest on previous years’ vested equity compensation.

When Your Company Needs to Obtain a 409a Valuation

First, an Independent Appraisal valuation only lasts twelve months. So, your company should plan on obtaining one at least annually if it wants to have the ability to consistently issue deferred equity compensation in compliance with Section 409a.

Second, the valuation via Independent Appraisal only lasts twelve months if an event that “materially affects the value of the corporation” has not occurred in the interim.  Here are some examples of material events that could re-trigger the company’s obligation to undergo another 409a valuation:

  • The resolution of material litigation (explicitly mentioned in the regulations)
  • The issuance of a patent (explicitly mentioned in the regulations)
  • A debt or equity financing
  • Undergoing any sort of merger or acquisition
  • Launching a central product or service of the company.

Note that this is a non-exhaustive list, but should give you a good idea of what would be considered a material event.

Finally, the entire 409a valuation process typically takes around two weeks to complete if you are organized and have all your documents ready to go.  However, most startups aren’t, which can extend the process to a month or even longer.  Waiting for a 409a can hold up equity grants, which can have a negative ripple effect on your organization.  So, be sure you are organized and current, and ready for the valuation process.

Conclusion

In sum, Section 409a is a very complex statute, and this post is just the tip of the iceberg. Always consult with an attorney if you have any questions, and always feel free to contact me.

Carney Badley Spellman is about Advocacy, Strategy, Results. Located in Seattle, we are a full-service law firm committed to exceptional client service and professional excellence. Our firm serves individuals and businesses of all types and sizes. Our attorneys also work with closely-held companies to Fortune 500 corporations in the Pacific Northwest and across the United States. Although Carney Badley Spellman‘s location is in Seattle, Washington, we are proud to be a part of the Washington state community and communities across the nation.

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